FIRPTA Compliance in a Depressed Real Estate Market
While compliance with the withholding requirements under the Foreign Investment in Real Property Tax Act (FIRPTA) usually is a routine matter in real estate closings, a depressed real estate market can create a number of problems for closing attorneys. This article will highlight particular areas of concern.
FIRPTA Compliance in General
As a general rule, Internal Revenue Code section 1445(a) requires the transferee (for simplicity, “buyer”) of a “U.S. Real Property Interest” (USRPI) from a foreign transferor (“seller”) to deduct and withhold tax equal to 10 percent of the “amount realized” (generally, the gross sales price) by the foreign seller on the transfer unless an exemption applies: For example, withholding generally is not required when the seller furnishes a proper certificate of nonforeign status at closing. A buyer who intends to use the purchased property principally as a residence can elect to forego FIRPTA withholding so long as property’s selling price is $300,000 or less, but utilization of this exception generally is not in the best interest of the buyer, as discussed below.
The withholding obligation also may be reduced or eliminated when a “withholding certificate” is obtained from the Internal Revenue Service (IRS). Generally, the buyer is required to remit the withheld tax to the IRS within 20 days following the closing, along with Forms 8288 and 8288-A. But if the seller properly notifies the buyer at or before closing that the seller has applied for a withholding certificate, the buyer should not send the withheld tax and forms to the IRS until the withholding certificate is received, usually well after closing. But note that the buyer still has to withhold the full 10 percent at closing, (usually pursuant to a satisfactory escrow arrangement using buyer’s counsel as the escrow agent), pending receipt of the withholding certificate from the IRS.
The definition of a USRPI in Code section 897 is fairly broad and complex, but this article will cover only the typical USRPI, real property located in the United States. Also, the FIRPTA rules applying to transfers of stock in U.S. corporations are beyond the scope of this article, as are the special rules applying to dispositions by, or dispositions of interests in, partnerships, trusts, or estates and the special rules applying to like-kind exchanges involving foreign parties.
Insufficient Proceeds to Cover FIRPTA Withholding
In a normal real estate market, the 10 percent withholding requirement typically does not pose a problem because the sale would generate sufficient proceeds to pay off mortgages and other closing expenses. A foreign seller may not be happy about the withholding, but it is an advance payment against the tax due with the required federal income tax return. If the withholding exceeds the tax actually due, the FIRPTA regulations provide a way for the seller to get a refund even before filing the tax return.
But a sale by a foreign seller may be impded where the proceeds are insufficient to cover the 10 percent withholding requirement. In a more wonderful world, the buyer and seller would have checked with their respective counsel prior to signing the contact, but that rarely happens in reality. The typical real estate contract (at least those used in Florida) contains sparse reference to FIRPTA compliance, and may even be inaccurate or misleading.
More often, the parties focus only on the withholding issue a few days before closing. But there may not be enough time even if the parties are astute enough to consider the withholding issue earlier. The IRS is supposed to act on an application for a withholding certificate within 90 days of receipt of all required information, but in practice the 90-day period is rather aspirational. And if the foreign seller (or a foreign buyer) is an individual lacking an Individual Taxpayer Identification Number (ITIN), additional delay will ensue because the application will have to be sent to the IRS ITIN Unit with Form W-7 and supporting documentation.
The only real remedy here is for the seller to advance its own separate funds (or borrow on a short-term basis) to allow the withholding pending receipt of the IRS withholding certificate. While not advised, a buyer faced with the prospect of losing an attractive deal might advance the funds, hopefully with sufficient interest or other compensation for the buyer’s risk. In such cases, counsel should carefully review the withholding certificate application to verify that it is in order, that it makes an appropriate case that no tax will be due (or at least none above the anticipated amount), and is well documented.
Counsel should also remember that if the seller’s tax liability is ultimately determined to be equal to 90 percent or more of the amount that was otherwise required to be withheld and paid over, the IRS will presume that the principal purpose of the application was to delay payment to the IRS of the amount withheld and will assess interest and penalties on the amount due against the party filing the application. Although not entirely clear, it appears that these penalties could be assessed against the buyer, which is a good reason to let the seller make the application. While the presumption can be rebutted, the parties may want to agree by contract that the seller will bear the burden of any assessed interest and penalties and the cost of any dispute with the IRS.
Counsel should be aware that tax may be due on a sale even when there is insufficient cash to fund the withholding, because a foreign seller who acquired the property before the recent hyper-inflated real estate market may have a low tax basis but a very large mortgage based on subsequent appreciation. For example: a foreign individual seller who bought a U.S. residence in 1987 for $200,000, and refinanced for $800,000 in 2006 when it appraised at $1,000,000, and who is now lucky to be selling for $810,000, would owe $91,500 in federal income tax at the applicable capital gains rate.
Applying for a withholding certificate would not help the seller in this case, and may not be a sufficiently attractive alternative to other foreign sellers even in less dire circumstances. They may be tempted to look instead for ways to avoid the FIRPTA withholding requirement and the U.S. tax burden. Counsel for buyer and seller should be alert to avoid getting caught up in the typical schemes used by sellers for this purpose.
- False Non-Foreign Certificate. To avoid withholding from U.S. citizens and entities or foreigners who have become subject to federal income tax on their worldwide income, Code section 1445 provides that withholding is not required if the seller provides at closing a “non-foreign certificate” under penalties of perjury. A foreign seller may be tempted to give a false certification to avoid withholding and federal income tax liability on the sale.
As the statutory withholding agent, the buyer is fully liable for any nonwithheld amount and is subject to applicable penalties and interest for noncompliance While attorneys, title agents, or others involved in a FIRPTA closing may not be directly liable as a withholding agent, Code section 1445(d) imposes an unusual obligation on a person classified as a “transferor’s agent” or a “transferee’s agent,” defined below. If the closing is proceeding without full FIRPTA withholding based on a false nonforeign certification from a transferor, then (a) a transferor’s agent or transferee’s agent who has actual knowledge that the affidavit is false, or (b) if the transferor is in fact a foreign corporation (regardless of the agent’s knowledge), the transferor’s agent, must timely notify the buyer and the IRS in writing that the certification is false. Failure to provide timely written notice to the transferee and to the IRS renders the agent liable up to the amount of the agent’s compensation from the transaction. However, an agent who assists in the preparation of, or fails to disclose knowledge of, a false certification or statement may be liable to the IRS for other civil or criminal penalties.
The regulations require that written notice to the transferee be given as soon as possible after the agent learns of the false certification but not later than the date of the transfer and prior to the transferee’s payment of consideration. If an agent belatedly learns of a false certification after the date of the transfer, notice must be given by the third day following that discovery. The notice must state that the certification is false and may not be relied upon. Although the notice need not disclose the information on which the agent’s statement is based, the notice must also explain the possible consequences to the recipient of failure to withhold. The regulations provide an acceptable form of notice. The agent must also provide a copy of the notice to the IRS at a specific address given in the regulations. The copy to the IRS must be accompanied by a cover letter stating that the copy is being filed pursuant to the requirements of Regs. section 1.1445-4(c)(2).
In a standard real estate closing, a “transferor’s agent” and “transferee’s agent” is any person who represents the seller or buyer (respectively) in any negotiation with another person (or another person’s agent) relating to the transaction; or in settling the transaction. Persons who only perform only ministerial functions are not classified as transferor’s or transferee’s agents.
The regulations provide that a nonforeign certificate must be retained for five years after the closing. In practice, the certificate should be designated for perpetual retention, as a buyer (particularly a foreign buyer) may need it to prove FIRPTA compliance on acquisition of the property. Note also that recent changes to the regulations require revision to the certification forms used by U.S. corporations, with a new form to be used for “disregarded entities” such as single-owner limited liability companies.
- Transfers Out of Corporate Ownership. To protect against federal estate tax on a U.S. real estate investment, foreign investors often use a foreign corporation, directly or through a U.S. subsidiary, to acquire the investment. Unfortunately, this worthwhile protective device has a downside, gain on disposition of the investment being subject to federal corporate income tax rates up to 35 percent and state income tax where applicable, compared to a potential 15 percent federal capital gains rate if the investment were held by the foreign individual. A foreign investor holding U.S. real estate through a corporate structure may be tempted to cause the corporation to convey the property to the individual beneficial owner in anticipation of a sale to a third party, in order to try to pay federal income tax at the lower individual capital gains rate. What this overlooks is that the transfer from the corporation to the individual itself generally is a taxable event at the corporate level, requiring tax reporting and withholding at 35 percent of the gain or, where applicable, compliance with FIRPTA’s complex nonrecognition transaction procedures. The IRS also has the option to disregard the corporate transfer to the shareholder and treat the transaction as a direct sale by the corporation.
A real estate attorney representing a buyer should be alert for indicia of such transfers (such as the sales contract or a title report that reflects the corporation as the current owner, since the deed to the shareholder is just being recorded) and refuse to cooperate with the fiction of a sale by the individual, in order to avoid any implication that the buyer or the buyer’s representatives may have aided and abetted federal income tax evasion by the seller.
- Transfers Into Corporate Ownership. Reportedly, some foreign individual or corporate sellers are seeking to avoid FIRPTA withholding by contributing the U.S. real estate to a U.S. corporation just before a sale to a third party. While the contribution of the property to a U.S. corporation may be effected free of federal income tax, compliance with the FIRPTA nonrecognition transaction rules is required and other federal income tax issues may arise. The more significant issue, however, is the implication that the seller may be trying to avoid federal income tax on the sale, because the putative seller now would be a U.S. entity that can give the buyer a nonforeign certification to avoid withholding, and disappear without the corporation filing a federal income tax return or paying tax due. Another tip-off to potential federal tax abuse is an instruction by the individual foreign shareholder to remit the closing proceeds to him or her rather than to the selling entity. Counsel should also be wary of transfers into a U.S. limited liability company, trust or partnership structure.
- Gifts of U.S. Real Estate. Another potentially abusive device is a gift of U.S. real estate to a spouse or child preceding a sale to a third party. While there might be a legitimate nontax motivation involved, the apparent gift may be a noncompliance signal if it results in reduction or avoidance of FIRPTA withholding tax on the subsequent sale, such as when the donee is a U.S. tax resident. In addition, such transfers (whether or not in contemplation of a sale) generally cause a federal gift tax exposure, without benefit of the unlimited marital deduction or unified credit that U.S. donors use to (legally) avoid or reduce gift tax, and the donee does not receive a step-up in the property’s tax basis. Regardless of FIRPTA, real estate counsel should caution their foreign clients against making any gift of a U.S. real estate interest.
- Sale of Stock in Foreign Corporation. As noted above, foreign investors may choose to own U.S. real estate through a foreign corporation (with or without a domestic subsidiary) for legitimate reasons. In such cases, FIRPTA taxation and withholding does not apply to a sale of stock in the foreign corporation. Assuming no recent transfer to the foreign corporation, this is not an abuse issue, but it is a risk to an unadvised buyer because the federal income tax avoided at closing the stock sale remains in the foreign corporation. The buyer thus inherits the tax liability, and for most U.S. persons ownership of U.S. real property through a foreign corporate structure can create additional U.S. tax and reporting issues.
- The Dangerous $300,000 Exemption. For reasons illustrating the old adage about legislation and sausage, Code section 1445 exempts from FIRPTA withholding the sale of a USRPI to a buyer who intends to use it as a personal residence (not necessarily the principal residence) when the amount realized by the transferor is $300,000 or less. But allowing a foreign seller to use this so-called exemption creates unacceptable risks to the buyer merely to accommodate the seller’s FIRPTA withholding problem.
To qualify under this exemption, the buyer (and certain family members, including brothers and sisters, spouse, ancestors, and lineal descendants) must intend to reside at the property for more than 50 percent of the number of days (excluding days the property is vacant) that the property is used by any person(s) for residential purposes during each of the two years following the purchase. The seller’s use of the property is irrelevant to the buyer’s intent.
No form need be filed to claim the exemption, but the seller remains liable to pay tax on the sale. Because use of the exemption does not require any FIRPTA filing, the seller does not have to apply for an ITIN until it is ready to file the federal income tax return reporting the sale, and obviously may be tempted not to file the return since the IRS likely will remain unaware of the sale.
This “exemption” is dangerous for buyers. If the residence test is not met for any reason the buyer is liable for the foregone withholding tax unless he or she can prove that the failure to meet the test was due to a change of circumstances that could not reasonably have anticipated at the time of the purchase. The “affidavit of intent” frequently used at such closings is likely no better than self-serving for the buyer, although it might protect buyer’s counsel against a potential malpractice claim by the transferee if accompanied by an adequate explanation of the law and the risks involved. In some cases, it helps to explain to the buyer that the seller still owes the tax on any gain, and that the seller is trying to shift a burden to the buyer. If the transaction is audited by the IRS, the buyer will incur substantial legal fees, costs and angst even if the buyer prevails. A buyer should not take this risk without some compensation, such as a meaningful reduction in the purchase price.
The personal residence exemption does not apply to a foreign partnership’s property disposition nor to an entity’s acquisition of a residential property. It does not apply to commercial property or raw land, even if the transferee intends to build a personal residence on the property, and is questionable if the transferee intends to knock down an existing residence and build a new one, even if the new residence will be a personal residence.
When to Seek Help from Tax Counsel
Real estate counsel should seek assistance from tax counsel well-versed in FIRPTA compliance in the following (nonexclusive) circumstances:
- When there has been a recent prior transfer among parties related to the transferor, including a gift or a transfer to or from a corporation or other entity, particularly if the transfer occurs after the date of the contract for sale.
- When you represent the transferor and the transferor is an estate, trust (including a land trust) or partnership.
- When the transferor is applying for a withholding certificate, particularly if the basis for the application is (1) other than a simple claim that the federal income tax due on the sale is less than the 10 percent withholding amount, (2) is on a “nonstandard” basis, or (3) the applicant is checks “Yes” on Box 9 of Form 8288-B.
- When any claim for nonrecognition treatment is made by the transferor.
- Any 1031 exchange.
- When a foreign party refuses to apply for an ITIN.
- Any installment sale.
- A foreign corporation claims U.S. status under Code section 897(i).
- A sale of stock in a U.S. corporation that may own substantial real estate.
- Any sale of real estate in which there is foreign financing.
Jonathan H. (Jason) Warner practices in Miami, Florida, concentrating on international tax matters. He is a former chair of the Florida Bar Tax Section and a principal participant in the Section’s FIRPTA withholding tax project. He has been named the Section’s Outstanding Tax Lawyer for 2007-2008.
© Copyright 2008, American Bar Association.